Saturday, February 16, 2008

The Student Loan Crisis Revisited

By Richard Vedder

As I and my sidekick Bryan pointed out a couple of days ago, the world is waking up to a reality: lending to college kids with zero credit history and highly uncertain future earnings is a risky business --unless the feds guarantee repayment. As a consequence, those in the private student lending business are taking a bath, and Wall Street investors are looking at these companies roughly the same way that 14th century Europeans looked at plague victims during the Black Death --warily and with more fear than love.

We have heard of how our great banks have been seriously damaged by the subprime crisis and defaulting mortgages. However, it is interesting to compare the share prices of broader based financial services companies with those of companies mainly involved with student loans. Below we look at the prices of five big financial services companies, including the three largest commercial banks --Citigroup, JP Morgan Chase, Bank of America, Merrill Lynch, and Bear Stearns --and compare them with three student loan firms --SLM Corp. (Sallie Mae), Nelnet Corp., and Student Loan Corp. We calculate two stock market indices --a broad based index of the first five companies (using an unweighted average of prices), and a student loan index of the last three companies, all indexed around the closing stock prices last June 29 being set equal to 100.

Here are the two index values for various dates:

Date

Financial Services Index

Student Loan Company Index

June 29, 2007

100

100

September 30, 2007

93.02

83.60

December 30, 2007

73.06

47.46

Febuary 15, 2008

70.95

45.19

The point made here is that, on average, the bad home equity, subprime and mortgage loans made by mainline banks and other companies have hurt them far less (29 percent stock price decline on average) than the loan activity of the student lenders (55 percent average stock price decline). LENDING TO STUDENTS IS RISKY. The price of Citigroup stock has fallen less (49 percent) than that of Sallie Mae (62 percent). (Citigroup, by the way, also is in the student loan business, but it has been relatively less important than it is for Sallie Mae).

All of this realization is leading to the Great Student Loan Credit Crunch of 2008. Congress, as usual, deserves part of the blame, with its stupid laws slashing administered fees (which should be set by market forces) on government guaranteed loans --so even that segment of the market is in some trouble as companies exit the business. The private market is in worse shape, as some of the lenders (including the Michigan Student loan authority) are unable to borrow money themselves at any reasonable interest rate. Where is junk bond king Michael Milken when we need him?

Will students be able to get loans this fall? In general, the answer is yes. Markets are innovative and responsive. People want to make a buck. The industry giant, SLM Corp. says it has lined up mega bucks worth of financing. But the costs will rise to students --at a time when the college-high school earnings differential may have stopped widening. If college and universities persist in raising tuition rates at double the rate of inflation something novel might happen: applications might start falling (demographics are pointing for that to happen anyhow in a couple of years). Will this lead to some real price competition in higher ed? I doubt it given the non-profit third party payment driven nature of the industry, but who knows? Out of crises and distress markets solve fundamentally unsustainable economic situations, and this appears to be the case here, although government involvement, the machinations of the Accreditation Cartel and other forces mute the ability of markets to work their magic. Watch for more from CCCAP on this topic: I expect my colleague Andy Gillen will soon finish an expanded and polished version of his "bubble" blogs that attracted some attention on this site earlier. They were insightful and spot on, as the world is finally realizing.

3 comments:

This is not a credit event w/ student loans, it's a liquidity event. A lot of the noise this week has to do with auction rate securities. This market collapsed last week and not just for student loans. A lot of state FFELP lenders rely heavily on this market (as do the for-profit FFELP lenders). The bond insurer issue is weighing heavily over the market right now. If these guys are downgraded (Ambac, MBIA, and so on), it means more loses for the financial sector as banks have to write-down the value of their investment portfolios. Some estimate another $200 billion in losses. That's got everyone skitish, and sitting on the sidelines.

A lot of the smaller FFELP lenders have had to exit the business because they don't have the balance sheets to eat the losses from today's financing costs like the big boys do. It doesn't help that as a FFELP lender, you are subject to volatility in your cost of capital that you can't pass along to the customer as you correctly point out b/c of government interference.

It's a great time for those who support the Federal Direct Loan Program (FDLP) which is entirely run by the government since any loss of market share by FFELP will presumably be a gain for FDLP. I know of no other industry where the government directly competes against private enterprise.

The evidence comes in in pieces. One bit of bad news here and one there. Today, the FT reported that US banks had tapped the Fed’s Term Auction Facility for over $50 billion in the last few weeks. As one analyst pointed out "The TAF ... allows the banks to borrow money against all sort of dodgy collateral,” says Christopher Wood, analyst at CLSA. “The banks are increasingly giving the Fed the garbage collateral nobody else wants to take ... [this] suggests a perilous condition for America’s banking system.”

The news that Credit Suisse (NYSE: CS) had "found" $2.85 billion in write-downs for asset-backed paper was not terribly encouraging. It is certainly an indication that banks are still having substantial problems valuing assets which are based on a weakening housing market and do not trade because of a locked-up credit markets. The banks can guess at the value of what they hold, but have no way to know for certain.

There is also an emerging body of analysis which says that large banks may have to write-down about $15 billion in LBO loans in the early part of this year. According to The Wall Street Journal "the extent of the damage is likely to emerge as banks file their annual reports next month and report first-quarter results in April."

None of these calculations take into account the falling value of paper backed by student loans, credit card debt, or loans for car purchases. They also leave out a potentially massive hit if bond-insurers like MBIA (MBI) or Ambac (ABK) face cuts in their credit ratings.

The total market in LBO debt now runs around $200 billion. The size of the mortgage-back and consumer-credit markets can only be guessed at. Write-downs for some of these securities have not begun in earnest.

The debacles at AIG (AIG) and Credit Suisse are surely a sign that financial companies and their auditors are having trouble putting a dollar amount on assets for which there is not market.

Every sign, and that is every sign, points to bank and brokerage write-downs in 2008 which will make 2007 seems like a picnic.